Retirement Preparation Without Tax Preferences? Part 2

In Part 1, I noted that three retirement experts recently asserted that America’s “tax deferred” retirement plans and programs “… do little to increase retirement saving. …”^[i] and that “…Revenues saved from repealing the retirement saving tax preferences could be reallocated to address the majority of Social Security’s long-term funding gap.”^[ii]

It may take a while, but such changes may end employer-sponsored retirement plans as we know them.

Retirement Tax Preferences Spur Savings—What Happens When They are Removed?

‘On the one hand, but on the other hand’—certainly, economists disagree.^[iii] As often attributed to President Truman in response to an economist who gave him such non-committal advice, he supposedly asked aides to find him “a one-handed economist.”

Congress giveth and taketh away. We do have one example that curtailed a tax preference while leaving others mostly in place. With “Universal IRAs … Congress passed the Economic Recovery Tax Act of 1981 (ERTA) to spur economic growth through multi-year tax reductions”.^[iv] IRA contributions rose sharply as many developed a ‘retirement savings habit’—61% of IRA owners contributed every year from 1982 through 1986.

But, when Congress eliminated “Universal IRA” deductibility, IRA contributions in 1987 declined 63%! And contributions declined by 30% among lower income Americans—even though their contributions continued to be tax deductible!

Distribution of Tax Preferences

The authors note that tax deferrals favor high earners who are more likely to have access to and participate in employer-sponsored plans and to contribute more than lower-wage earners when they do participate.

The authors cite data from the Urban Institute/Brookings Institution that 59.2% of current tax expenditures flow to the top quintile of income distribution. However, would you be surprised to hear that the Tax Policy Center estimates that 67% of income taxes collected for 2022 came from those in the top quintile^[v]. Data from the Tax Foundation shows that the top quintile had about 68.8% of the reported income and paid 86.6% of all income taxes!^[vi] So, is anyone surprised whose taxes are deferred?

Obviously, with the number of tax-qualified, employer-sponsored DC accounts approaching 120 million, the current system prompts many to save for retirement—not just those in the top quintile.

With respect to the employer contribution, almost all top quintile earners have wages that exceed the Social Security Wage Base. So, subjecting employer contributions to both employment and income taxes would add employer costs that are much greater for lower compensated employees than highly paid workers.^[vii]

Would Savings Earmarked for Retirement Decline?

The authors of the study say yes, by a third:

“… the economists’ lifecycle model suggests that people may simply shift their saving from ordinary taxable investment accounts to tax-favored retirement accounts in order to reap the benefits of the tax preference. If we assume that 65 to 70 cents of each dollar of retirement plan savings otherwise would have been saved in taxable investment accounts, about $644 billion of the $954 billion in annual retirement plan contributions would have occurred regardless…”

I wonder about those assumptions. If there were no DB pensions, no DC retirement plans and no IRAs, Traditional or Roth, how would anyone know what was saved and earmarked for retirement? A better estimate might come from comparing saving for retirement between those who participate in an employer-sponsored plan and those who are not eligible for an employer-sponsored plan—keeping in mind that the tax preferences for Roth and Traditional IRAs are much the same as for deferrals to a 401k plan.^[viii]

To quote one of the study authors:

“… At any given time, only about half of private sector workers in the United States are covered by an employer-sponsored retirement plan, and few workers save without one. …”^[ix]

Much will depend on whether the employers who already sponsor a plan continue to do so. And, just as importantly, will the employers continue to take fiduciary risks in selecting investments, deploying automatic features, and other actions because, without employer-sponsored plans, little saving occurs.

Will Employers Continue to Offer Plans Once Tax Preferences are Removed?

Based on my 31+ years in plan sponsor roles for four different Fortune 500 employers, and 14+ years in corporate benefits consulting, the answer is No!^[x]

The experts note: “It is important to remember that retirement plans existed before the income tax, so tax benefits are clearly not the only reason employers sponsor retirement plans.” However, in years before the income tax became an everyday part of American life in 1913^[xi], there were only a handful of pension plans. More importantly, there weren’t other tax-favored benefit plans.

The experts also note that: “Employers viewed DB pensions as a valuable tool for managing their workforce. These plans provided benefits based on final pay and years on the job. As a result, the value of pension benefits increased rapidly as job tenure lengthened, which motivated employees to stay with the firm. DB plans also encouraged employees to retire when their productivity began to decline.”^[xii]

However, median tenure of American workers has been less than 5 years for the past seven decades^[xiii]—I know of no one who is predicting a change in that trend.

Many believe that ‘defined contribution plans help employers attract and retain “top talent” or high-quality workers.’^[xiv]No. Benefit plans like the 401k with their broad-based eligibility, vesting and non-discrimination rules do not differentiate “top” from “not-so-top” talent.

“Corporate benefits 101” justifies an offer of employee benefits (as opposed to greater direct compensation (wages, incentives, etc.) with more worker control) only where:

There are tax preferences only available in those benefits,
There are products and processes that are not otherwise available in the individual marketplace, and
There are group dynamics, efficiencies, risk management, and economies of scale that cannot otherwise be achieved.

Where none of those three exist, benefits should not exist—there should be a preference for cash compensation and worker control on how to best allocate rewards.

Without the tax preferences, what business justification is there for employers to take on fiduciary duties, legal exposure, and additional expense?

The authors suggest elimination of the tax preference might create a need for a national retirement savings mandate—perhaps similar to England’s NEST program. However, the opt out rates would be significant. For comparison, see the “opt out” rates for state mandated retirement savings programs with Roth IRAs—imagine the opt out rates should the federal government end Roth IRAs?^[xv]

Removing Tax Preferences May REDUCE FICA & FICA-Med Revenues!

Employers are not potted plants. Expect employers to shift their spending to medical, dental, vision, life, and LTD. Expect them to increase employer contributions, perhaps change to a matching formula on worker deferrals via a cafeteria plan—Dependent Day Care Flexible Spending Accounts, Health Flexible Spending Accounts and especially Health Savings Accounts.

If a sizable portion of current savings migrate from 401k plans to Health Savings Accounts, the revenue losses to Social Security and Medicare would increase! Is that possible? Yes. The revenue loss to Treasury, Social Security and Medicare would be immediate because employer and worker contributions to Health Savings Accounts are primarily made through the operation of a cafeteria plan—where contributions are pre-tax for FICA, FICA-Med, federal income tax, and almost all state income taxes.

The 2022 median contribution rate to employer-sponsored plans among participating workers was 6.4% of income (ignoring those who were eligible but not contributing) and median income in the United States in 2022 was $40,480.^[xvi] So, a shift from 401k to HSA is possible for most workers—those at or below the median wage who contribute the median percentage of pay ($40,480 * .064 = $2,591)—where both the worker deferral combined with a 50% employer matching contribution would be less than the HSA maximum contribution of $3,650 (2022), $3,850 (2023), and $4,150 (2024)—the HSA maximum contribution is double those amounts for those with non-single HSA-capable coverage.

Few would be surprised to see the Health Savings Account “replace” a considerable portion of 401(k) savings. It is already a better vehicle for income replacement after age 65 with greater tax preferences. Even better, the HSA has greater utility^[xvii]—capable of quadruple duty (tax-free reimbursement of out-of-pocket expenses and certain medical premiums today, similar tax-free reimbursement for various medical expenses in retirement including Medicare Part B and Part D premiums, penalty tax-free income replacement after age 65, and survivor benefits).

And why wouldn’t employers respond by increasing adoption of non-qualified, deferred compensation plans?

Removing Tax Preferences May Increase Entitlement Spending, Liabilities!

Some states have adopted mandatory, tax-preferred Roth retirement savings initiatives—in part because they believe greater accumulations of tax preferred retirement savings will reduce entitlement spending.

“… limited savings could lead to a cumulative additional cost to the federal government of $964 billion between 2021 and 2040. State spending on these programs, stemming from administrative costs, required state match formulas, and supplemental state benefits, totals another $334 billion over that period. And social spending does not replace the entirety of the gap, requiring many households to reduce their standard of living in retirement.”^[xviii]

For example, in 2019, there were 12.2 million dually eligible (low-income retirees) enrolled in both Medicare and Medicaid. Combined Medicare and Medicaid spending on dually eligible beneficiaries totaled $440.2 billion of which Medicaid accounted for $164.3 billion (37 percent).^[xix] Actions that would substantially reduce saving/retirement preparation could significantly increase already substantial entitlement spending among the aged who lack accumulated savings.

By encouraging retirement preparation with tax preferences, fewer older Americans live in poverty.

My suggestion to the authors who suggest we might eliminate tax-preferences for employer-sponsored retirement plans is to consider the wisdom of Yogi Berra: “It’s tough to make predictions, especially about the future,” and, “The future ain’t what it used to be.”

• Economists Refute Biggs-Munnell Plan to Repeal 401(k) Tax Preferences to Boost Social Security

I am always interested in your comments, corrections, criticisms, and suggestions. Send them to me at jacktowarnicky@gmail.com

Disclaimer No. 1: My comments are my own based on my past experiences in plan sponsor and consulting roles and do not necessarily reflect those of any employer or association I have been employed by or affiliated with, past, present, or future.

Disclaimer No. 2: Information was provided by individuals with knowledge and experience in the industry and not as legal or tax advice. The issues presented here may have tax and legal implications, and you should discuss this matter with tax and legal counsel prior to choosing a course of action. This article is intended to be informational only. It is not and you/others should not use it as a substitute for legal, accounting, actuarial, tax or other professional advice. Any advice contained in this article was not intended or written to be used and cannot be used by anyone for the purpose of avoiding any Internal Revenue Code penalties that may be imposed on such person [or to promote, market or recommend any transaction or subject addressed herein. You (others) should seek advice based on your (their) particular circumstances from an independent tax advisor.

^[i] A. Biggs, A. Munnell, M. Wicklein, The Case for Using Subsidies for Retirement Plans to Fix Social Security, Center for Retirement Research at Boston College, WP 2024-1, 1/1/24, Accessed 1/25/24 at: https://crr.bc.edu/wp-content/uploads/2024/01/wp_2024-1-1.pdf

^[ii] Ibid.

^[iii] Poterba, Venti, and Wise (Fall 1996) conclude that IRA and 401(k) plan contributions represent new savings, while Engen, Gale, and Scholz (Fall 1996) conclude that the bulk of retirement saving has been reallocated from other savings. Gustman and Steinmeier (August 1998) find limited displacement, if any, and that pensions add to total wealth by at least half the value of the pension. Shefrin and Thaler (October 1988) suggest that people engage in “mental accounting,” dividing up their financial resources into buckets that they tap for current consumption at differing frequencies. Money allocated to a special retirement savings bucket is less likely to be spent than other available funds and thus more likely to remain as savings.

^[iv] S. Holden, K. Ireland, V. Leonard-Chambers, M. Bogdan, The Individual Retirement Account at Age 30: A Retrospective, Investment Company Institute, February 2005, Accessed 1/27/24 https://www.ici.org/doc-server/pdf%3Aper11-01.pdf

^[v] P. G. Peterson Foundation, Who Pays Taxes? 3/24/23. Accessed 1/25/24 at: https://www.pgpf.org/budget-basics/who-pays-taxes#

^[vi] E. York, Summary of the Latest Federal Income Tax Data, 2022 Update, 1/20/22, Accessed 1/15/24 at: https://taxfoundation.org/data/all/federal/summary-latest-federal-income-tax-data-2022-update/

^[vii] Author’s Note: The Social Security Wage Base for 2024 is $168,600. The Internal Revenue Code defines “Highly Compensated Employee,” generally, as an individual who received more than $150,000 in compensation in the 2023 tax year and was in the employer’s top 20% in pay. In the 2024 tax year, that amount increases to $155,000. Keep in mind that the tax preferences at issue here are only possible where the retirement plan incorporates a variety of eligibility, vesting and non-discrimination rules designed to ensure that highly compensated employees do not receive benefits that are substantially greater than non-highly compensated employees.

^[viii] Investment Company institute, The Role of IRAs in US Households’ Saving for Retirement, 2021, January 2022, “Only 13 percent of US households contributed to traditional or Roth IRAs in tax year 2020.” Accessed 1/25/24 at:https://www.ici.org/system/files/2022-01/per28-01.pdf

^[ix] A. Munnell, What’s Preventing More Small Businesses from Offering Retirement Plans? 1/10/24, Accessed 1/25/24 at: https://crr.bc.edu/whats-preventing-more-small-businesses-from-offering-retirement-plans/

^[x] Author’s Note: I’m reminded of Professor Ezekiel Emanuel’s prediction regarding employer-sponsored health plans following adoption of the Patient Protection and Affordable Care Act of 2010 (with its “Cadillac Tax”. E. Emanuel, Reinventing American Health Care, How the Affordable Care Act Will Improve our Terribly Complex, Blatantly Unjust, Outrageously Expensive, Grossly Inefficient, Error Prone System, 4/16/14. “End of employer-sponsored health insurance. Fewer than 20% of workers in the private sector will receive traditional employer-sponsored health insurance.”

By Ezekiel J. Emanuel

^[xi] The 16^th Amendment to the U.S. Constitution was passed by Congress on July 2, 1909, and ratified February 3, 1913.

^[xii] A. Biggs, A. Munnell, M. Wicklein, note 1, supra.

^[xiii] Census Bureau, “Employee Tenure,” 9/22/20. Accessed 7/29/23 at: www.bls.gov/news.release/pdf/tenure.pdf . See also: C. Copeland, “Trends in Employee Tenure, 1983-2018,” Employee Benefits Research Institute, 2/28/19. Accessed 7/29/23 at: www.ebri.org/content/trends-in-employee-tenure-1983-2018. See also: H. R. Hamel, “Job Tenure of Workers,” Monthly Labor Review, Bureau of Labor Statistics, January 1967.

^[xiv] A. Glaze, Why Offering Retirement Benefits Helps Attract And Retain Top Employees, 8/24/22, Accessed 1/27/24 at: https://www.forbes.com/sites/forbesfinancecouncil/2022/08/24/why-offering-retirement-benefits-helps-attract-and-retain-top-employees/?sh=6ef4677e3710

^[xv] J. Towarnicky, State Mandated, Payroll-Deducted IRAs, 20X, 15X, 12X More Likely to Save? Not Really! 12/27/22, Accessed 1/25/24 at: https://401kspecialistmag.com/state-mandated-payroll-deducted-iras/ J. Towarnicky, Maryland’s State-Run IRA Is Different, Better, and Still Less Than Optimal. At this point, ALL Maryland workers would be better served by saving in a superior alternative. 9/16/22, Accessed 1/25/24 at: https://401kspecialistmag.com/marylands-state-run-ira-is-different-better-and-still-less-than-optimal/ J. Towarnicky, State-Run IRAs Are Similar, and Suboptimal: Opinion Payroll deduction is so 20th Century, 6/29/22, Accessed 1/25/24 at: https://401kspecialistmag.com/calsavers-is-similar-to-oregonsaves-and-suboptimal-opinion/ J. Towarnicky, Retirement Savings Crisis: Access Isn’t the Issue, Prioritization is, 2/26/21, Accessed 1/25/24 at: https://401kspecialistmag.com/retirement-savings-crisis-access-isnt-the-issue-prioritization-is/

^[xvi] Vanguard, How America Saves, 2023, Accessed 1/25/24 at: https://institutional.vanguard.com/content/dam/inst/iig-transformation/has/2023/pdf/has-insights/how-america-saves-report-2023.pdf See also: St. Louis Federal Reserve Bank, Median Personal Income in the United States, 2022, Accessed 1/25/24 at: https://fred.stlouisfed.org/series/MEPAINUSA646N

^[xvii] J. Towarnicky, Maximum Utility: Your HSA Can Do Quadruple Duty, Benefits Quarterly, 2^nd Quarter 2021

^[xviii] J. Scott, A. Blevins, State Automated Retirement Programs Would Reduce Taxpayer Burden from Insufficient Savings: Study shows potential combined $1.3 trillion burden for state and federal governments over 20 years, Pew Trusts, 5/11/23, updated 6/2/23.

^[xix] L. Seegert, Clearing up confusion about dual eligibles, Association of Health Care Journalists, 1/25/24, Accessed 1/28/24 at: https://healthjournalism.org/blog/2024/01/clearing-up-confusion-about-dual-eligibles/ See also: MACPAC, Medicaid and CHIP Payment and Access Commission, Accessed 1/28/24 at: https://www.macpac.gov/topics/dually-eligible-beneficiaries/#